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Growth of cloud subscription model

Courtesy of blogs.idc.com

Fifteen years ago, software was sold under a perpetual license model only.  Usually, it was also sold “as is” without any customization or modifications to suit customers needs.  However, the growth of the internet has allowed the software sales model to evolve.  Today, most software is at least customized to fit the needs of customers and it is also sold under a subscription model that grants access as required, rather than the perpetual license which grants unlimited access to the software in perpetuity.  Since the business model has changed, so has the accounting and software revenue recognition rules have become much more complex.  This post will help software companies understand the accounting behind the subscription services business model.

The first question that firms need to ask themselves when using a subscription model is whether the arrangement should be accounted for as a software sale or as a service sale. If it is a software sale, then it is recognized following the rules outlined within ASU 2009-13 regarding revenue recognition in multiple element arrangements. However, if the software is actually sold as a service, or SaaS model, then revenue recognition needs to follow the rules established by SAB 104 and SOP 97-2.

The simplest way to determine which guidance is applicable is to submit the arrangement to the following two questions:

  1. Does the customer have a contractual right to take possession of the software at any time during the hosting period without significant penalty?
  2. Is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software?

If “yes” is the answer to both questions, then the arrangement should be treated like a software sale. However, if either one is “no”, then the arrangement should be treated as a service sale.

Differences between software sale and service sale

Courtesy of esi.mil

Once you have determined that it is a service arrangement, revenue should be recognized over the subscription period. The only time this might not be the case is if an arrangement contains some kind of usage-based fee. Then revenue would be recognized when the usage occurs.

However, if access to the software was the only significant portion of the contract, then the CFO’s job would be easy. Usually though, the subscription fee that was negotiated includes multiple bundled elements like training, and consulting. To recognize revenue for these elements, software companies need to separate each bundled element from the arrangement and track the price separately. Companies need to determine whether each element contains vendor specific object evidence (standalone value) and recognize revenue over the expected life of that agreement. If these additional elements were negotiated separate from the subscription, then the company needs to recognize the revenue when the deployment is completed.

Characteristics of SaaS business model

Courtesy of esi.mil

Subscription models are extremely appealing to software companies because of their potential for profit and their promise of steady cash flow. For these models to work effectively, the accounting revenue recognition rules must be followed. If you would like to discuss the effects of software revenue recognition rules on your company, please contact us today.